Misunderstanding profit

When it comes to business reports, the concept of profit has to be one of the most misinterpreted items on a company’s balance sheet. What is it, what does any particular number mean, and why are some companies posting insane profit numbers while not “sharing the wealth”? Well let’s get into this.

Now “profit” is not really an accounting term. When people say that a company posted a certain amount of profit, or wrote off a particular amount of losses for a given fiscal period, they’re typically talking about the income statement item called “Net income”.

In the simplest terms, profit is simply income minus expenses, but when talking about corporate accounting, the concept of “profit” isn’t nearly that simple. You see the one thing few understand about corporate and business accounting — and this applies to personal accounting as well — is simply not all disbursements of cash are expenses.

All cash transactions fall into one of three categories: expenses, asset acquisition, or liability reduction.

Of those three, only expenses count against the company’s net income. The other two don’t count against the net income for the fiscal period as reported in the income statement, but they do show up in the cash flow statement. The lay person sees a deduction from their bank account as an expense, whether that deduction is a liability payment or to buy groceries. In business accounting, though, this is not the case. The liability payment is an increase in the firm’s equity, not an expense, as the expense was accounted for earlier when the liability was taken.

From Wikipedia:

Due to the nature of double-entry accrual accounting, retained earnings do not represent surplus cash available to a company. Rather, they represent how the company has managed its profits (i.e. whether it has distributed them as dividends or reinvested them in the business). When reinvested, those retained earnings are reflected as increases to assets (which could include cash) or reductions to liabilities on the balance sheet.

Let’s complicate things more.

Revenue comes in two forms: cash and receivables. A receivable is money owed to you. For businesses, a receivable is typically a credit contract. When the contract is tendered, the business will record in their ledger as revenue the value of the contract. Cash that is paid against the receivable is not revenue and does not affect the total assets held by the company.

Expenses come in various forms that I’m not going to discuss here as I’d be writing out a ton.

* * * * *

Let’s have a look at everyone’s favorite corporation: Wal-Mart!

Now in January 2014, Wal-Mart reported a total net income of $16.022 billion. Now the lay person thinks that Wal-Mart’s cash holdings went up by $16 billion, but that is not the case. Indeed their balance sheet shows their cash holdings actually went down between January 2013 and 2014 by about a half billion dollars. So where the hell did all that cash go?

Let’s start with the larger numbers: Wal-Mart’s net revenue as of January 2014 was $476.294 billion, out of which comes $358.069 as cost of good sold and employee wages, salaries and benefits. Next come other expenses, including over $8 billion in taxes, $2.3 billion in interest expenses, until we get the net total income of $16.022 billion. Now again their balance sheet reports their cash holdings went down by over a half billion dollars. So what happened?

Their cash flow statement provides the details and shows a net cash flow of -$500 million. Start with the $13 billion in capital expenditures and go from there.

But it should be clear that a company that posts a $16 billion net income is not sitting on $16 billion in cash, and net income is not the same as profit. Net income is an income statement line entry. Profit is total change in assets minus total change in liabilities, meaning Wal-Mart’s actual profit according to their January 2014 balance sheet compared to January 2013 is a loss of $88 million including a $500 million loss in cash.

This also means that arguing that certain companies, like Wal-Mart, can afford to pay their employees more or provide better benefits simply because of the profits they posted is disingenuous as it doesn’t take the company’s cash flows into account. To get a true sense as to whether a company posts a profit or loss, you need to look at the balance sheet and compare the change in equity over the previous year. You also need to look at the cash flow statement to see if their total cash flow resulted in the company retaining cash or spending more than they took in.